Bite-sized basics: The difference between principal and interest and interest only

Posted by Owun Taylor

When buying a property, choosing a mortgage can be overwhelming due to the many different features. The first question you’ll be asked when setting up investment property finance is “do you want Interest-Only or Principal & Interest repayments?” For some of you this might seem like such a basic question, but trust me it’s not quite as simple as flipping a coin.

Let’s start off with some definitions:

The principal is the money that was originally lent to a borrower.
Interest is the cost of borrowing the principal.
No matter the loan type, the interest on the loan is calculated on a daily basis on the outstanding amount of the principal.

Interest-Only

With an Interest-Only mortgage, you pay only the interest charged on the loan and not the principal debt at all. Most lenders will only allow you to have an Interest-Only loan for a set period of time. Generally, that’s up to 5 years. After that period has ended, it will switch over to a Principal & Interest mortgage. However, it’s typically not difficult to sign into another Interest-Only period.

Since you are only paying the interest charged on your mortgage debt, your regular repayments are significantly lower than that of a Principal & Interest mortgage. This type of loan is often appealing to first-time buyers and owner-occupiers who wanted to keep their regular mortgage repayments as low as possible (maybe because they were doing a renovation on their home).

Interest-Only is the most popular mortgage with personal investors, meaning people who have purchased the property in their own name. In this instance, it’s because they don’t necessarily want to pay down their mortgage debt in order to maximise their tax benefits. The tax benefit is called negative gearing. This describes a situation where expenses associated with the asset, including interest expenses are greater than the income earned from the asset.

Principal & Interest

A Principal & Interest mortgage, sometimes abbreviated to just P&I, means that your repayments have two portions, the ‘principal’ and the ‘interest’ component. A portion of the repayment is used to pay off the interest amount due on your outstanding loan and the remaining is the principal portion, which slowly goes towards paying off the outstanding loan amount itself.

In a nutshell, this is the mortgage for owner-occupiers, for a few basic reasons.

Unlike with investment properties, there are no tax deductions for our homes. Because of that, the sooner you start paying off your principal mortgage debt on your home, the lower the total interest bill will be and the faster you are going to build up equity. That can become incredibly useful down the track when we want to leverage the equity in the home property to buy more investments.

For investors who have purchased the property in their personal names, an Interest-Only loan is generally the preferred option (see the previously written blog on negative gearing). However, when investors purchase property in a trust as part of their Self-Managed Super Funds (SMSF) the plan changes slightly. When we buy in an SMSF we are not buying and holding the property in our personal names. The property is now being held in a separate entity (a trust that is part of your super-fund). If an SMSF has borrowed money to purchase a property, the loan must be structured as a “limited recourse borrowing arrangement” (LRBA), which requires the loan to be a principal and interest loan.

What should you pick?

I’m not going to tell you what you should be doing from just reading this blog and it’s also not something that you should decide after a chat on a Sunday afternoon BBQ with that well-meaning friend who just so happened to have googled it last week.

As part of your being a clever investor, decisions around subjects like this are part of your plan that will need to be reviewed over the years. You absolutely need to check in with your finance team, (accountant, financial advisor and of course your lovely Blue Wealth Property Investment Property Specialist) to help you make these decisions.

Owun

Knowledge is Power

Owun is the Senior Education Specialist at the Blue Wealth Property Academy and hosts The Clever Investor podcast. He has worked in finance and property for well over 20 years and is known for being able to explain the complex world of wealth creation in an easy-to-understand way.

Posted by Owun Taylor, on 14th Feb 2023